June Emerging Markets Debt Update

Monthly Commentary

The external backdrop remained challenging in the second quarter, with Emerging Markets (EM) sovereign dollar-debt returning -3.54%, corporate debt, -2.87%, and local currency debt faring the worst, returning -10.40%. While the initial leg of
the sell-off was driven more by higher U.S. rates and a stronger dollar, more recently the market has been under pressure due to growth concerns and heightened
trade tensions.

Our base case for Emerging Markets has been underpinned by a synchronized global growth recovery, which has been called into question amidst weaker-than-expected growth data in Europe and several Emerging Markets countries against stronger U.S. growth. While we still believe that the differential between EM and Developed Markets (DM) growth will widen over the next 12-18 months, current above-trend growth in the U.S. and slowing EM growth, particularly in Latin America, has narrowed the extent of this divergence.

We believe key for a recovery in returns in 2H18 is a rebound in growth outside the U.S. While it is too early to make a definitive call, we are starting to see signs of stabilization in non-U.S. growth. In addition, an uptick in Developed Markets wage inflation should translate into increased capex, which positively impacts EM via the trade channel. Another positive dynamic in EM is the abatement of election-induced uncertainty, except for Brazil. In addition, outside of the Fed, we believe that DM central banks are likely to remain dovish, in response to the weaker data during the first half. Similarly, China is acting in a countercyclical fashion, providing a targeted activity stimulus.

The key risk to this narrative is the rising trade tension. While we believe the direct impact for EM from the announced measures is limited, an escalation of a trade war and a potential business confidence shock could derail the growth recovery.

We would further note the following:

Vulnerability around the asset class has declined, particularly when compared to the taper tantrum period. Current account deficits and inflation levels are lower, and fiscal deficits have been improving. In addition, we believe EM economies are in the early to mid-stage of their business cycle, as opposed to the U.S., which is arguably in the later stages.

Emerging Markets, in our view, can handle gradual U.S.
rate hikes in the context of improving growth (consider
2017 as an example). Rate volatility, however, tends to
spook markets, and the risk is that U.S. inflation picks up
materially and unexpectedly, forcing the Fed to hike at a
faster pace. Rising U.S. rates will present challenges for
those EMs that have a large stock of USD-denominated
debt and are dependent on foreign financing (e.g. Turkey).
But overall, our view is that EM balance sheets are healthy,
with many economies in a much better position to handle
higher U.S. rates than they were during the 2013 taper
tantrum period, due to bigger reserve cushions and
undervalued exchange rates.

We believe tail risks around China have declined
compared to several years ago due to more balanced
capital flows, well-executed currency management, and
the growth in services and other emerging sectors. The
short-term economic impact of trade tariffs is limited
for China, as only 3.5% of Chinese output is consumed
in the U.S. Nonetheless, rising policy uncertainty over
trade and investment barriers is likely to dampen business
sentiment and capex both in China and the U.S. China
will likely retaliate proportionally against the U.S. trade
and investment restrictions, and depending on the U.S.
reaction, risks are rising that this could go beyond the
initial $50 billion of exports. China, in our view, has tools to
withstand this, and notably, recently announced measures
to provide counter cyclical support to the economy and
lessen the impact of tariffs including cuts in tariffs on
other countries’ exports, income taxes and banks’ reserve
requirements. We do not believe that China will retaliate
against U.S. trade measures by actively depreciating their
currency, as it could be destabilizing to their own financial
markets. That said, China is unlikely to resist a market-led
CNY depreciation, though they will likely step in to limit the
pace of depreciation and keep markets orderly.

Outside of a few emerging markets that are highly
dependent on exports to the U.S., such as Mexico and
Vietnam, we do not believe that rising protectionism by
itself is enough to derail the EM growth story, although it
is likely to have a negative impact on sentiment. Abovetrend
growth in the U.S. (turbo-charged by fiscal stimulus)
and continued solid growth in China provide an important
foundation for emerging markets growth over the balance
of the year.

Recent European economic surprises data has turned
positive. This could signal a return to synchronous global
growth, although as mentioned, it is too early to make this
call. If further data supports this conclusion, we believe the
strength of the U.S. dollar will taper off as investors shift
their focus from cyclical factors to the structural issues
facing the U.S. economy. This, in turn, would alleviate
pressure on EMFX and provide further support to the EM
growth story.

Idiosyncratic EM risks have declined as a number of
elections have now occurred (Turkey, Mexico). Brazil
remains as a source of uncertainty with elections in the fall
and no clear leading candidate.

We have had a significant repricing in both the dollardenominated
and local currency markets. Emerging Markets
dollar-denominated debt spreads are 110 basis points (bps)
wider from the tights of late January, ending the quarter at
approximately 370bps. At the beginning of the year, we felt
that credit spreads globally were tight, and that there was
more of a relative value story between Emerging Markets and
Developed Markets credit. Now, it appears to us that not only
is EM cheap to DM, but EM is also moderately cheap relative
to its own history, one of very few asset classes about which
this can be said. In fact, 16% of global fixed income still trades
at negative interest rates. And, while there is no science to
this, historically, the 400bps spread level on the EMBI has
been a strong signal to add.

In addition, EM currencies are down 35% versus the dollar
on average since the time of the taper tantrum and the local
currency index is down close to 11% from its strongest point
this year alone. We question the sustainability of the recent
U.S. dollar strength. In our view, the large U.S. tax cuts are
likely to exacerbate concerns about the return of a “twin
deficits” problem in the U.S. (i.e. large fiscal deficit combined
with a large current account deficit) which has historically
been a negative for the dollar. In addition, technical
positioning exacerbated the 2Q move higher in the U.S. dollar,
as market participants entered the year very short the dollar
versus other currencies. We would argue that a good amount
of these positions have been cleared out, resulting in more
balanced dollar positioning.

Yields between dollar-denominated debt and local currency
debt have converged to approximately 6.5%, making the
return story relatively balanced for the remainder of the year, in our view. We believe that there are some pretty interesting
opportunities in local currency debt, but this segment of the
market will likely be more volatile in the near term amidst
concerns about trade policy and the potential for continued
dollar strength.

We believe that the main risks to our thesis, which do not
represent our base case, are as follows: 1) a global trade
war, with the U.S. becoming much more aggressive in
its protectionist efforts versus China, Europe and others,
and/or a serious consideration of leaving the World Trade
Organization, 2) an unexpected pickup in U.S. inflation,
which is not inconceivable amidst low unemployment,
high oil prices and a large fiscal stimulus, and 3) a further
increase in U.S. growth relative to the rest of the world (which
appears a little more challenging given where the U.S. is in
its business cycle, in addition to the fact that the stronger
dollar has put pressure on corporate profitability). In these
scenarios, we would envision a continued rise in the dollar
and higher U.S. rates. This would put downward pressure
on EM growth and upward pressure on inflation. Finally, this
is the first time that the financial markets are going through
the withdrawal of QE. As such, it is difficult to predict with
precision the impact on risk markets. We view EM balance
sheets as healthy – fiscal deficits have fallen over the last
several years and, as mentioned, the bulk of funding is issued
locally – but it is something we are watching closely.

We are seeing institutional investors add exposure via
both hard and local currency debt to take advantage of this
downtrade. We believe that the next few months will be
volatile, but could present an interesting opportunity to add
risk. But in any case, investors seeking to add exposure should
consider scaling in, rather than in a single trade, as volatility
is likely to continue for a while. In a market with close to
70 countries, security selection and country differentiation
remain key in this environment.